Mastering Corporations and Other Business Entities

00 harris final 11/4/08 2:48 PM Page i

Carolina Academic Press Mastering SeriesRussell L. Weaver, Series Editor

Mastering BankruptcyGeorge W. Kuney

Mastering Civil ProcedureDavid Charles Hricik

Mastering Corporations and Other Business EntitiesLee Harris

Mastering Criminal LawEllen S. Podgor, Peter J. Henning, Neil P. Cohen

Mastering EvidenceRonald W. Eades

Mastering Intellectual PropertyGeorge W. Kuney, Donna C. Looper

Mastering Legal Analysis and CommunicationDavid T. Ritchie

Mastering Negotiable Instruments (UCC Articles 3 and 4) and Other Payment Systems

Michael D. Floyd

Mastering Products LiabilityRonald W. Eades

Mastering Professional ResponsibilityGrace M. Giesel

Mastering Secured TransactionsRichard H. Nowka

Mastering Statutory InterpretationLinda D. Jellum

Mastering Tort LawRussell L. Weaver, John H. Bauman, Ronald W. Eades,Andrew R. Klein, Edward C. Martin, Paul J. Zwier II

00 harris final 11/4/08 2:48 PM Page ii

Mastering Corporations and Other Business Entities

Lee HarrisUniversity of Memphis

Cecil C. Humphreys School of Law

Carolina Academic PressDurham, North Carolina

00 harris final 11/4/08 2:48 PM Page iii

Copyright © 2009Lee Harris

All Rights Reserved.

Library of Congress Cataloging in Publication Data

Harris, Lee, 1978-Mastering corporations and other business entities / Lee Harris.

p. cm.Includes index.ISBN 978-1-59460-444-7 (alk. paper)

1. Business enterprises--Law and legislation--United States. I. Title. II.Title: Mastering corporations and other business entities.

KF1355.H37 2008346.73'066--dc22

2008041490

Carolina Academic Press700 Kent Street

Durham, NC 27701Telephone (919) 489-7486

Fax (919) 493-5668www.cap-press.com

Printed in the United States of America

00 harris final 11/4/08 2:48 PM Page iv

Contents

Table of Cases xiii

Series Editor’s Foreword xvii

Preface xix

Acknowledgments xxi

Chapter 1 · Agency Law 3Roadmap 3A. Introduction to Agency Law 3

1. Legal Consequences of Agency Relationship 32. Economic Consequences of Agency Relationship 4

B. Formation of Agency Relationship 51. Consent to Act 52. Control Is Vested with the Principal 7

C. Imputed Knowledge 9D. Contract Liability 10

1. Express Actual Authority 102. Implied Actual Authority 103. Apparent Authority 124. Inherent Authority 135. Agency by Estoppel 146. Agency by Ratification 16

E. Tort Liability 171. Scope of Agent’s Authority 182. Independent Contractor Exception 193. Limits of Independent Contractor Exception 20

F. Agent Duties 211. Agent Duty of Loyalty 212. Other Agent Duties 22

v

00 harris final 11/4/08 2:48 PM Page v

G. Principal’s Duties to Agent 23H. Disclosed and Undisclosed Principals 23

1. Undisclosed Principals 242. Disclosed Principals 25

I. Co-Agents and Sub-Agents 25J. Termination of Agency Relationship 26Checkpoints 28

Chapter 2 · General Partnerships 29Roadmap 29A. Introduction 29B. Sources of General Partnership Law 30C. Definition of Partnership 31D. Evidence of Formation 31E. Right to Control and Share in Profits 33

1. Right to Control 332. Right to Share Profits (or Losses) 34

F. Partnership Liability 361. Introduction to Partnership Liability 362. Limiting Partners’ Authority to Bind 373. Other Limits on Partnership Liability 39

G. Partnership Fiduciary Duty 401. Duty of Loyalty 402. Duty of Care 443. Obligation of Good Faith and Fair Dealing 45

H. Partnership Change in Control 461. Transfer of Partnership Interest 462. Admission of New Partners 473. Dissolution 484. Dissociation 505. Expulsion of Partner 51

Checkpoints 52

Chapter 3 · Introduction to Limited Liability Entities 53Roadmap 53A. Advantages of Limited Liability 54

1. Investment 542. Monitoring 553. Fairness 56

vi CONTENTS

00 harris final 11/4/08 2:48 PM Page vi

4. Valuation 56B. Disadvantages to Limited Liability 57

1. Monitoring 572. Moral Hazard 58

Checkpoints 58

Chapter 4 · Limited Partnerships 59Roadmap 59A. Introduction 59B. Sources of Limited Partnership Law 60C. Formation 62

1. Certificate of Limited Partnership 622. Partnership Agreement 643. Incongruent Writings 64

D. Introduction to Fiduciary Duty 651. Duty of Care and Loyalty 652. Obligation of Good Faith and Fair Dealing 67

E. Right to Control 67F. Right to Share in Profits and Losses 68G. Right to Sue 68H. Limited Partner Liability 68

1. The Control Rule 692. Other Issues in Limited Partner Liability 71

I. General Partner Liability 71J. Change in Control 72

1. Dissociation and Admission 722. Transfer of Corporate Partner Stock 73

K. Dissolution of a Limited Partnership 741. Dissolution by Consent 742. Constructive Dissolution 743. Certificate of Dissolution 75

Checkpoints 76

Chapter 5 · Limited Liability Companies 77Roadmap 77A. Introduction 77

1. The Appeal of LLCs 772. Brief History of LLCs 79

B. Source of Law 80

CONTENTS vii

00 harris final 11/4/08 2:48 PM Page vii

C. Formation 811. Certificate of Formation 812. The Operating Agreement 82

D. Governance 841. Management 842. Owner Classes 85

E. Fiduciary Duty 851. Duty of Loyalty 862. Duty of Care 873. Good Faith and Fair Dealing 88

F. Introduction to Liability 891. Piercing the Company Veil 892. Individual Misconduct 92

G. Dissociation 941. Buyouts 942. Expulsion 95

H. Dissolution 96Checkpoints 97

Chapter 6 · Corporate Formation 99Roadmap 99A. Introduction to the Corporate Form 99

1. History of the Firm 100B. Source of Law 101

1. Delaware General Corporate Law 1012. Model Business Corporate Act 102

C. Pre-Incorporation 1021. Promoter Liability 1032. Promoter Duties 105

D. Corporate Formation 1071. Articles of Incorporation 1072. By-Laws 1083. Amendment of By-Laws or Articles 109

E. Defective Formation 1091. De Facto Corporations 1092. Corporations by Estoppel 111

F. Dissolution 113Checkpoints 114

viii CONTENTS

00 harris final 11/4/08 2:48 PM Page viii

Chapter 7 · Corporate Characteristics, Capital Structure,and Management 115

Roadmap 115A. Transferability of Shares 115B. Limited Liability 116

1. Veil-Piercing 1172. Theory and Evidence in Veil-Piercing 121

C. Double Taxation 122D. Capital Structure 123

1. Shares 1232. Options 1243. Debt 125

E. Introduction to Corporate Management 125F. Corporate Officers 125G. Board of Directors 127

1. Introduction to the Powers of the Board of Directors 1292. Power over Internal Operations 1293. Power to Distribute Earnings 1304. Power to Delegate 131

H. Shareholders 132I. Dual Managerial Responsibilities 133Checkpoints 133

Chapter 8 · Fiduciary Duty of Care 135Roadmap 135A. Introduction to the Business Judgment Rule 136

1. Reasons for the Business Judgment Rule 1372. Applications of the Business Judgment Rule 139

B. Statutory Director Protections 1411. Expert Reports 1422. Indemnification and Insurance 1443. Exculpatory Charter Provisions 145

C. Exceptions to the Business Judgment Rule 1471. Failure of Oversight 1482. Uninformed Decision-Making 1513. Irrational and Wasteful Decisions 1544. Law-Breaking 157

D. Obligation of Good Faith 158Checkpoints 160

CONTENTS ix

00 harris final 11/4/08 2:48 PM Page ix

Chapter 9 · Fiduciary Duty of Loyalty 161Roadmap 161A. Introduction to Duty of Loyalty 162B. Corporate Opportunities 162C. Introduction to Self-Interested Transactions 169

1. Ratification by Directors 1702. Ratification by Shareholders 172

D. Rule of Entire Fairness 174E. General Limits of the Duty of Loyalty 175

1. Transactions Involving All Shareholders 1752. Trivial Transactions 177

Checkpoints 177

Chapter 10 · Shareholder Rights and Remedies 179Roadmap 179A. Right to Inspect 180

1. Limits on Right to Inspect 181B. Right to Vote 183

1. Voting Methods 1852. Interference with Right to Vote 187

C. Right to Sue 1881. Derivative versus Direct Actions 1892. Demand Requirement 1913. Futility 1934. Special Litigation Committees 196

D. Attorneys Fees and the Right to Sue 1981. An Analysis of Attorneys Fees 1982. Substantial Benefit Test 200

Checkpoints 201

Chapter 11 · Securities Fraud 203Roadmap 203A. Securities Fraud 204

1. Material Misrepresentation 2042. Reliance 2073. Causation 2104. Scienter 2115. Standing 212

B. Insider Trading 2121. Theory of Insider Trading 213

x CONTENTS

00 harris final 11/4/08 2:48 PM Page x

2. Introduction to “Abstain-or-Disclose” Rule 2143. Insider Breaches of Fiduciary Duty 2154. Derivative Insider Breaches of Fiduciary Duty 2165. Misappropriation 218

Checkpoints 219

Chapter 12 · Proxy System 221Roadmap 221A. Introduction 221B. Independent Proxy Solicitations or Proxy Challenges 223

1. “Solicitations” 2242. Proxy Statement Expenses 2253. Proxy Statement Fraud 228

C. Shareholder Proposals 230Checkpoints 233

Chapter 13 · Takeovers 235Roadmap 235A. Introduction to Takeovers 235B. Dissenter Rights 236

1. Right to Notification 2372. Right to Vote 2373. Right to Appraisal 238

C. Statutory Takeovers 2381. Statutory Merger 2392. Substantial Sale of Assets 2393. Triangular Merger 2404. Freezeout Merger 2415. Short-Form Merger 2436. De Facto Mergers 244

D. Hostile Takeovers 245E. Defensive Measures 247Checkpoints 255

Mastering Corporations and Other Business Entities Checklist 257

About the Author 261

Index 263

CONTENTS xi

00 harris final 11/4/08 2:48 PM Page xi

00 harris final 11/4/08 2:48 PM Page xii

A.P. Smith v. Barlow, 98 A.2d 581(N.J. 1953), 130

AFSCME v. AIG, 462 F.3d 121 (2dCir. 2006), 231-232

American Vending Services, Inc. v.Morse, 881 P.2d 917 (Utah Ct.App. 1994), 112-113

Aronson v. Lewis, 473 A.2d 805(Del. 1984), 194

Bane v. Ferguson, 890 F.2d 11 (7thCir. 1989), 45

Basic v. Levinson, 485 U.S. 224(1988), 114, 207, 209

Beam v. Stewart, 845 A.2d 1040(Del. 2004), 193, 195-196

Blau v. Rayette-Faberge, Inc., 389F.2d 469 (2d Cir. 1968), 201

Botticello v. Stefanovicz, 411 A. 2d16 (Conn. 1979), 17

Brehm v. Eisner, 746 A.2d 244 (Del.2000), 143, 154-155, 158, 171-172

Brehm v. Eisner, 906 A.2d 27 (Del.2006), 143, 154-155, 158, 171-172

Broz v. CIS, 673 A.2d 148 (Del.1996), 166-169

Case v. Borak, 377 U.S. 426 (1964),229

Cheff v. Mathes, 199 A.2d 548, 556(Del. 1964), 249

Community Counseling Service,Inc. v. Reilly, 317 F.2d 239 (4thCir. 1963), 22

Direct Mail Specialist, Inc. v.Brown, 673 F.Supp. 1540 (D.Mont. 1987), 63

Dodge v. Ford Motor, 170 N.W.668 (Mich. 1919), 155-157

Dura Pharmaceuticals v. Broudo,544 U.S. 336 (2005), 210

Elf Atochem v. Cyrus, et al, 727A.2d 286 (Del. 1999), 83

Ernst & Ernst v. Hochfelder, 425U.S. 185 (1976), 211-212

Farris v. Glen Alden, 143 A.2d 25(Pa. 1958), 244-245

Fenwick v. Unemployment Com-pensation Commission, 44 A.2d172 (N.J. 1945), 32

Five Star Concrete v. Klink, 693N.E. 2d 583 (Ind. Ct. App.), 94-95

Fleigler v. Lawrence, 361 A.2d 218(Del. 1976), 173-174

Francis v. United Jersey Bank, 432A.2d 814 (N.J. 1981), 148-149

Gateway Potato Sales v. G.B. Invest-ment Company, 822 P.2d 490(Ariz. Ct. App. 1991), 71

Gay Jenson Farms v. Cargill, 309N.W.2d 285 (Minn. 1981), 8-9

xiii

Table of Cases

00 harris final 11/4/08 2:48 PM Page xiii

Gorton v. Doty, 69 P. 2d 136 (Idaho1937), 4

Gotham Partners, L.P. v. Hallwood,817 A.2d 160 (Del. Supr. 2002),65-66, 72

Green v. H & R Block, 735 A. 2d1039 (Md. 1999), 6-7

Grimes v. Alteon, 804 A.2d 256(Del. 2002), 126-127

Grimes v. Donald, 673 A. 2d 1207(Del. 1996), 131-132, 189-190,192-193, 195

Guth v. Loft, 5 A.2d 503 (Del.1939), 163-169

Haley v. Talcott, 864 A. 2d 86 (Del.Ch. 2004), 96-97

Hariton v. Arco Elec., 188 A.2d 123,125 (Del. 1963), 244

Hill v. County Concrete, 672 A.2d667 (Md Ct. Spec. App. 1996),110-111

Hirsch v. Silberstein, 227 A. 2d 638(Pa. 1967), 24-25

Hoddeson v. Koos Bros., 135 A. 2d702 (N.J. Supr. 1957), 15-16

Holzman v. De Escamilla , 195 P.2d833 (Cal. Ct. App. 1948), 70

Hoover v. Sun Oil, 212 A.2d 214(Del. 1965), 19-20

Humble Oil & Refining Co. v. Mar-tin, 222 S.W.2d 995 (Tex. 1949),20

Hunt v. Rousmanier’s Administra-tors, 21 U.S. 174 (1823), 27-28

In Re Asian Yard Partners, 1995 WL1781675 (Bankr. D. Del. 1995),73-74

In Re Caremark, 698 A.2d 959 (Del.Ch. 1996), 149-150

In re Fuqua Indus., 752 A.2d 126(Del. Ch. 1999), 189, 200

In re Oracle, 824 A.2d 917 (Del.Ch. 2003), 197-198

In Re the Limited, Inc. Sharehold-ers Litigation, No. Civ. A.17148-NC, 2002 WL 537692(Del. Ch. 2002), 190

In re Walt Disney Co. DerivativeLitig., 731 A.2d 342, 362 (Del.Ch. 1998), 143, 154-155, 158-159, 171-172

In Re Wheelabrator Technologies,Inc. Shareholder Litigation, 663A.2d 1194 (Del. Ch. 1995), 174

Ira Bushey & Sons v. United States,398 F. 2d 167 (2d Cir. 1968), 18-19

Jerman v. O’Leary, 701 P.2d 1205(Ariz. Ct. App. 1985), 67

Joy v. North, 692 F.2d 880, 885 (2dCir. 1982), 137

Kahn v. Lynch, 638 A.2d 1110 (Del.1994), 243

Kamin v. American Express, 383N.YS.2d 807 (N.Y Sup. Ct.1976), 140-141

Kaycee Land v. Flahive , 46 P.3d 323(Wy. 2002), 90

Kovacik v. Reed, 315 P.2d 314 (Cal.1957), 34-36

Lee v. Jenkins Brothers, 268 F.2d357 (2d Cir. 1959), 126

Long Island Lighting v. Barbash,779 F. 2d 793 (2d Cir. 1985),224-225

Majestic Realty Associates v. TotiContracting, 153 A.2d 321 (N.J.1959), 20-21

xiv TABLE OF CASES

00 harris final 11/4/08 2:48 PM Page xiv

McConnell v. Hunt,. 725 N.E. 2d1193 (Ohio Ct. App. 1999), 86-87

Meehan v. Shaughnessy, 535 N.E.2d1255 (Mass. 1989), 43-44

Meinhard v. Salmon, 164 N.E. 545(N.Y. 1928), 41-42

Mill Street Church of Christ v.Hogan, 785 S.W.2d 263 (Ky. Ct.App. 1990), 11

Miller v. AT&T, 507 F.2d 759 (3dCir. 1974), 157

Mills v. Electric Auto-Lite Co., 396U.S. 375 (1970), 229-230

Moneywatch v. Wilbers, 665 N.E.2d 689 (Ohio Ct. App. 1995),104-105

National Biscuit Company v.Stroud, (N.C. 1959), 37-38

New Horizon v. Haack, 590 N.W.2d 282 (Wis. Ct. App. 1999), 91

New York City Employees’ Retire-ment System v. Dole, 795F.Supp. 95 (S.DN.Y 1992), 232-233

Obert v. Environmental R & D, 752P.2d 924 (Wash. Ct. App. 1988),75

Page v. Page, 359 P. 2d 41 (Cal.1961), 48

Page v. Sloan, 190 S.E.2d 189 (N.C.1972), 21

Paramount Communications v.QVC Network, 637 A.2d 34 (Del.1993), 253

Paramount v. Time, 571 A. 2d 1140(Del. 1989), 253

Pepsi-Cola Bottling Co. v. Handy,2000 Del. Ch. LEXIS 52 (Del.Ch. 2000), 92

Pillsbury v. Honeywell,191 N.W.2d406 (Minn. 1971), 181-183

Ramey v. Cincinnati Enquirer, Inc.,508 F.2d 1188, 1199 (6th Cir.1974), 229

Reading v. Regem, 2 KB 268(1948), 22

Revlon v. MacAndrews, 506 A.2d173 (Del. 1986), 250-254

Robertson v. Levy, 197 A.2d 443,446 (D.C. 1964), 111

Rosenfeld v. Fairchild, 128 N.E.2d291, 293 (N.Y. 1955), 225, 227

Santa Fe Industries v. Green, 430U.S. 462 (1977), 6, 204-205

Schreiber v. Carney, 447 A.2d 17(Del. Ch. 1982), 188

Sea-Land Services, Inc. v. The Pep-per Source, 941 F.2d 519 (7thCir. 1991), 117-119

SEC v. Dirks, 463 U.S. 646 (1983),217-218

SEC v. TGS, 401 F.2d 833 (2d Cir.1968), 214-215

Shlensky v. Wrigley, 237 N.E.2d 776(Ill. App. Ct. 1968), 129-130

Sinclair Oil v. Levin, 280 A.2d 717(Del. 1971), 175-176, 241

Smith v. Van Gorkom, 488 A.2d858 (Del. 1985), 146, 151-154

Southern-Gulf v. Camcraft, 410 So.2d 1181 (La. Ct. App. 1982),111-112

State of Wisconsin InvestmentBoard v. Peerless, No. Civ.A17637, 2000 WL 1805376 (Del.Ch. 2000), 187

Stone v. Ritter, No. Civ. A. 1570-N,2006 WL 302558 (Del. Ch.2006), 159, 175

TABLE OF CASES xv

00 harris final 11/4/08 2:48 PM Page xv

Summers v. Dooley, 481 P.2d 318(Idaho 1971), 37-39

Three-Seventy Leasing Corporationv. Ampex, 528 F. 2d 993 (5thCir. 1976), 12-13

Topanga Corp. v. Gentile, 58 Cal.Rptr. 713 (Cal. Ct. App. 1967),105-106

U.S. v. Chiarella, 445 U.S. 222(1980), 215-216, 218

U.S. v. O’Hagan, 521 U.S. 642(1997), 218-219

Unocal v. Mesa Petroleum, 493A.2d 946 (Del. 1985), 248-250,252-253

VGS v. Castiel, 2000 Del. Ch.LEXIS 122 (Del. Ch. 2000), 88

Walker v. Resource Dev. Co., 2000Del. Ch. LEXIS 127 (2000), 95-96

Walkovsky v. Carlton, 223 N.E.2d 6(N.Y 1966), 119-120

Water, Waste & Land v. Lanham,955 P.2d 997 (Colo. 1998), 92-93

Watteau v. Fenwick, 1 QB 346(1892), 13-14

Weinberger v. UOP, 457 A.2d 701,713 (Del. 1983), 238, 241-243

xvi TABLE OF CASES

00 harris final 11/4/08 2:48 PM Page xvi

Series Editor’s ForewordThe Carolina Academic Press Mastering Series is designed to provide you with

a tool that will enable you to easily and efficiently “master” the substance andcontent of law school courses. Throughout the series, the focus is on qualitywriting that makes legal concepts understandable. As a result, the series is de-signed to be easy to read and is not unduly cluttered with footnotes or cites tosecondary sources.

In order to facilitate student mastery of topics, the Mastering Series includesa number of pedagogical features designed to improve learning and retention.At the beginning of each chapter, you will find a “Roadmap” that tells youabout the chapter and provides you with a sense of the material that you willcover. A “Checkpoint” at the end of each chapter encourages you to stop andreview the key concepts, reiterating what you have learned. Throughout the book,key terms are explained and emphasized. Finally, a “Master Checklist” at theend of each book reinforces what you have learned and helps you identify anyareas that need review or further study.

We hope that you will enjoy studying with, and learning from, the Master-ing Series.

Russell L. WeaverProfessor of Law & Distinguished University ScholarUniversity of Louisville, Louis D. Brandeis School of Law

xvii

00 harris final 11/4/08 2:48 PM Page xvii

00 harris final 11/4/08 2:48 PM Page xviii

PrefaceThe title of the basic business law course — Corporations, Business Associ-

ations, Business Organizations, or Business Entities — varies from law schoolto law school and from year to year. However, in these courses, the core cov-erage is essentially the same — agency principles, partnership law, fiduciaryduties, securities fraud, and changes in corporate control. This relatively con-cise book is intended to reach students in the basic corporate law course, re-gardless of course title. This book attempts to make the usual coverage as easyand straightforward as possible. Although the vast majority of law studentstake a business law course, there are surprisingly few attempts to systemati-cally organize the most important doctrine and theories covered. Of the fewbooks that track the basic business law course, even fewer still are of recentvintage. This book attempts to fill those lacunae.

The book intends to aid students, of course, in the basic Corporations orBusiness Organizations courses. Additionally, though, I should like to think thisbook would be a useful resource to students in other closely-related coursesin law school, like Agency & Partnership, Closely-Held Firms, Mergers & Ac-quisitions, and Securities Regulation, to name just a few. Outside of law schools,I am also writing with an eye toward the graduate student in business admin-istration who are frequently enrolled in a basic business law course and thenewly-minted corporate attorney who wants a refresher text. In addition to areview of the doctrine, I also want to give the reader a sense of the theory andhistory behind the more complicated concepts. With any luck, the book’s con-tribution to the theory and history of corporate law is as pervasive as the con-centration on doctrine.

xix

00 harris final 11/4/08 2:48 PM Page xix

00 harris final 11/4/08 2:48 PM Page xx

AcknowledgmentsI must acknowledge the University of Memphis, my permanent academic

home, and George Washington University, where, as a visiting professor, I wasin residence while writing much of this book. Both institutions are full of cre-ative thinkers, top-flight support staff and, of course, challenging students. Ithank the intrepid deans of those institutions, former dean Jim Smoot at theU of M and Dean Fred Lawrence at GW, for their generosity in providing mewith a wonderful place to complete this work. Additionally, I should like tothank those who have been particularly helpful along the way, including AlenaAllen, Regina Burch, Lawrence Cunningham, Janet Richards, Kevin Smith,Steve Schooner, and Russ Weaver. Lastly, I have had a handful of research as-sistants over the course of my writing this book, all of whom have been par-ticularly adept at turning inchoate assignments into gold. My research assistantshave included Jon Barnes, Michael Gore, Jason Koch, and Deric Ortiz at GW;and Lea Mullins, Jennifer Longo, and Bruce Shanks at the U of M.

LAH

xxi

00 harris final 11/4/08 2:48 PM Page xxi